Chapter 2 – Branch Equivalent Regime for Controlled Foreign Companies

2.1 Control Test
2.2 White List
2.3 Tax Preferences
2.4 Submissions
2.5 Dividends Received by a Controlled Company, Losses and Foreign Tax Credits

2.1 Control Test

2.1.1 The BE method would tax New Zealand shareholders on their proportionate shares of the undistributed income of foreign companies measured according to New Zealand tax rules. Thus, the method requires taxpayers to have all of the information necessary to recompute the taxable income of offshore companies. In practice, this information will generally not be available unless the resident(s) control the offshore company. In addition, as we have argued in section 1.5, it is unreasonable to tax residents on the undistributed income of offshore companies which they may never receive, unless they at least have access to it, that is, they have the power to require distribution if they wish. For these two reasons, the Committee recommends that the BE regime apply only where residents control an offshore company.

2.1.2 This would be in line with practice overseas, where BE-type regimes apply only where there is a controlled foreign company. Submissions were strongly in favour of a control test. This would not be a significant departure from the CD proposals since, in practice, the BE regime could be applied only where there is control.

2.1.3 A number of companies making submissions noted that their ability to repatriate profits from non-resident subsidiaries may be restricted because of exchange controls, governmental foreign investment requirements, or agreements made with co-venturers. Since businesses do not consciously make bad investment decisions, we would expect that the return generated from foreign subsidiaries in these circumstances will be higher than otherwise to reflect the constraints imposed. Thus, the New Zealand parent will generally expect to be able to gain access to the foreign subsidiary profits at some stage, though not necessarily to repatriate them, and be compensated for any impediments and time delays. Even if this were not the case, it would be impracticable to give relief from the BE regime merely because profit access restrictions exist because taxpayers could voluntarily enter into such arrangements to suspend the effect of the regime. It might also encourage foreign governments to impose repatriation controls on New Zealand investment. Where such restrictions currently apply to foreign subsidiaries, some relief will be provided by the transitional provisions recommended by the Committee.

2.1.4 The Committee has considered the appropriate control test after looking at several overseas models. Any test must of necessity be somewhat arbitrary since, in practice, there are no clearly defined criteria for control. We recommend defining control as the ownership of 50 percent or more of the shares (or rights to income, distributions on wind up, votes, etc) of a company by 5 or fewer residents. This is similar to the Canadian test and that proposed in Annex 4 of the 1987 Budget. It would be necessary to have a constructive ownership rule so that interests held in nominees and associated parties would be aggregated. In addition, we propose an anti-avoidance provision aimed at arrangements, such as voting trusts and understandings, which have the effect of defeating the intent and application of the control test. We would also add a de facto control test to cover situations such as where a shareholder has a right to require a distribution or the wind up of a company.

2.1.5 Where a non-resident company falls within the control test, all of its New Zealand shareholders or only the controlling ones could be subject to the regime. The Committee favour the latter approach because only controlling shareholders have access to the necessary information and the undistributed income of the company. Since there may be more than one group of 5 residents which satisfies the control test, we recommend that all resident shareholders of controlled companies with interests of 10 percent or more (hereafter referred to as "non-minor" shareholders) be subject to the BE regime. An exception should apply where control exists by virtue of the proposed anti-avoidance or de facto control provisions. In those cases, the residents deemed to have control should be subject to the regime in accordance with their proportionate interests.

2.1.6 Further details of the control provisions proposed by the Committee are contained in Annex 1.


2.1.7 The Committee therefore recommends that, in relation to foreign companies:

a the BE regime apply only where New Zealand residents have control of a company;

b control be defined as the ownership by 5 or fewer residents of 50 percent or more of the shares (or votes, rights to dividends or distributions on wind up) of a company, subject to:

i a constructive ownership test to include interests held through associated persons, nominees and other controlled companies;

ii a de facto control provision to include within the regime persons who have the power to require a distribution or the wind-up of a non-resident company; and

iii an anti-avoidance provision to deter arrangements which have the effect of defeating the intent and application of the control test; and

c resident shareholders who directly or indirectly hold a 10 percent or greater interest in a controlled company and residents who are deemed to have control by virtue of the de facto control and anti-avoidance provisions be subject to the BE regime, but other resident shareholders of controlled companies be exempt from it.

2.2. White List

2.2.1 One of the criticisms of the BE regime is that it would involve heavy compliance costs for possibly little revenue when it applied to companies in "high tax" countries, such as the United States and the United Kingdom. The compliance costs would be most acute for New Zealand's large internationally diversified companies, some of which have hundreds of offshore subsidiaries. In addition, the administrative costs of the regime would be high.

2.2.2 The United Kingdom, West Germany and France address this problem by having a so-called "white list" of countries. If a company is resident in a white list country and the large bulk of its income is sourced and subject to tax in such countries, it is exempt from the CFC regime.

2.2.3 In principle, it is desirable to minimise compliance costs where the revenue at stake is not material. The practical difficulty in this case is that the revenue loss relative to the compliance cost savings resulting from some form of list cannot readily be quantified. Nevertheless, the Committee recommends the adoption of a restricted list as a reasonable pragmatic compromise. We recognise that no list can be watertight and that there will be costs in compiling and updating it. These problems must be weighed against the need to reduce the compliance costs of the regime where it is unlikely that revenue would be collected.

2.2.4 Accordingly, the Committee favours a list, qualified by tax preferences as set out below, of countries which have comprehensive international tax rules including CFC regimes. At present, there are six - the United Kingdom, the United States, West Germany, France, Canada and Japan. We understand that Australia is currently considering the introduction of a CFC regime and, given our proposed transitional provisions (discussed in chapter 7), we recommend that Australia be included on the list. The existence or otherwise of a CFC regime gives the list an objective basis.

2.2.5 The United Kingdom white list is qualified by an income source rule to the effect that, to be exempt from the CFC regime under the white list provisions, controlled companies must derive at least 90 percent of their income in the (white list) country in which they are resident. This rule aims to ensure that, to qualify for exemption, the large bulk of the income of a controlled company must be subject to tax in a white list country. An alternative approach is to "look through" companies resident in white list countries to controlled companies beneath them. These lower tier controlled companies would be exempt only if they also satisfied the qualified white list test. The Committee favours this approach rather than an income source test, In addition, it would be necessary to list as a significant preference the exemption of foreign-source income where a listed country excluded it from its tax base. This is presently the case with France. We discuss the issue of foreign tax preferences in the next subsection.

2.3 Tax Preferences

2.3.1 In addition to having a white list, the United Kingdom has a qualified (or "grey") list which provides for exemption from the CFC regime only if the foreign company does not benefit from certain listed tax preferences. Many submissions argued that foreign tax preferences should be recognised under the BE regime to preserve the competitiveness of foreign subsidiaries of New Zealand companies. We commented briefly on the international competitiveness argument in section 1.5. The arguments against recognising foreign preferences are that:

a it would be inconsistent with domestic tax policy, which is generally to remove tax preferences. This policy would make no sense at all if foreign tax preferences were recognised under the BE regime since it would merely encourage New Zealand residents to invest offshore. If tax incentives were to be allowed as a matter of tax policy, it would be better to provide them domestically;

b tax preferences are only one form of investment subsidy. Other types of assistance that may be provided in other countries include grants, subsidised input costs, output bounties, tariff protection, concessional loans and provision of free services such as research. All of these would have the effect of increasing the profitability of foreign investments owned by New Zealand residents but the benefit of them would to some extent be clawed back under the BE regime. It would be impractical to preserve the effect of all types of assistance under the regime and we see no reason to preserve tax preferences in particular; and

c tax preferences are similar in effect to low or zero rates of tax. If the BE regime is to apply to controlled companies in low tax countries ("tax havens”), it should also apply to such companies in high tax countries where effective tax rates are low, not because of a low statutory tax rate, but because of tax preferences.

2.3.2 In addition, the trend amongst OECD countries is to phase out or remove tax preferences. This is certainly the case in the United States, the United Kingdom and Canada. As tax preferences are removed, effective tax rates in other countries will rise so that, since New Zealand's statutory tax rates will be amongst the lowest, if not the lowest, in the OECD, our effective tax rates should be comparable to those in the countries where most of New Zealand's offshore investment is located. The impact of the BE regime on the competitiveness of New Zealand-owned foreign companies will therefore diminish as the trend away from preferences continues.

2.3.3 In the Committee's view, the arguments against recognising foreign tax preferences under the BE regime outweigh the counter arguments. We therefore favour the qualification of the proposed white list by the identification of significant tax preferences in each country. As noted above, this qualified list is referred to as a grey list. Taxpayers would be required to adjust the taxable income of a CFC resident in a listed country, measured according to that country's tax rules, for any identified significant preferences that the CFC has utilised. If the foreign tax paid as a proportion of the adjusted taxable income equals or exceeds the New Zealand company tax rate, the taxpayer would be exempt from the regime in respect of that CFC. In our view, the reduction in the New Zealand statutory company tax rate removes the need to base this effective tax rate comparison on two-thirds of the statutory rate, as proposed in Annex 4 of the 1987 Budget.

2.3.4 The comprehensiveness of the list of preferences is largely a matter of tax policy. New Zealand tax policy has been to eliminate explicit preferences. This may suggest a relatively extensive list, though materiality and compliance costs must be taken into account.

2.3.5 A number of submissions argue that the claw back of foreign tax preferences would be inconsistent with a number of New Zealand's tax treaties which include tax sparing provisions. These provisions generally apply only to branches of New Zealand companies in the tax treaty country and, since foreign branches are not affected by the present reforms, tax sparing would not be withdrawn or diminished. We are satisfied that the BE regime does not breach a tax treaty obligation. The tax sparing provisions were, however, entered into before the introduction of the present proposals and may now appear to be inconsistent with the thrust of the reforms.


2.3.6 The Committee therefore recommends that:

a residents be exempt from the BE regime in respect of interests in companies which are:

i resident for tax purposes in certain listed countries with comprehensive international tax regimes including CFC regimes (i.e.the United States, the United Kingdom, West Germany, Canada, France and Japan) or Australia; and


ii do not benefit from specified significant tax preferences in those countries such as accelerated capital write-offs or the exemption of certain foreign-source income. Where a company did utilise a specified preference, it would be required to adjust its taxable income, determined according to the country of residence tax rules, for the effect of the tax preference(s). If its foreign tax paid as a ratio of its adjusted taxable income equals or exceeds the New Zealand company tax rate, the BE regime would not apply; and

c non-minor shareholders (and other shareholders deemed to have control) in a controlled company who have interests which are held indirectly through other foreign companies be subject to the regime unless the controlled company satisfies the exemption outlined in recommendation (a).

2.4 Submissions

2.4.1 Most submissions were in favour of a CFC regime along the lines of those applying in other countries. The two main differences between the regime proposed by the Committee and CFC regimes elsewhere are that:

a other CFC regimes generally make a distinction between so-called "active" and "passive" income. The latter is generally regarded as internationally "mobile" income such as interest, dividends, royalties and related party sales and service income;

b in some cases, the CFC regimes are to some extent targeted on tax haven CFCs. The United States and Canada do not, however, target tax havens in this way.

2.4.2 The artificiality of the distinction between active and passive income is best illustrated in the case of shares. A share portfolio of, say, one percent stakes in 100 companies is regarded as a passive investment even though each company may itself be an active business. Conversely, a 100 percent holding in a single company is regarded as a direct or active investment. In the first case, an interest is held in 100 active businesses. In the second case, an interest is held in one active business. In both cases, the income of the shareholder consists of dividends and capital gain on the shares. Though these investments may differ in other respects, both are ultimately investments in active businesses. Thus, there are boundary problems in distinguishing between active and passive investments.

2.4.3 Another problem with the active/passive income distinction arises with certain classes of income. For example, interest income is regarded as active business income when it is earned by a financial institution but passive income when derived by other businesses. If the regime employed this distinction, banks could shelter interest income while other businesses would reorganise themselves in an attempt to resemble banks or they would establish finance subsidiaries which were difficult to distinguish from banks. This problem has forced the United States to include within its definition of CFC (i.e, subpart F) income dividends, interest and realised gains from the disposition of shares and other securities, regardless of the nature of the business deriving them. For similar reasons, subpart F income now includes income from the insurance of risks outside the insurer's country of incorporation.

2.4.4 Finally, the advantages of low tax rates and tax preferences are the same whether they apply to active or to passive income. In view of these considerations, the Committee considers that there is no merit in distinguishing between different classes of income.

2.4.5 The argument for targeting the BE regime on tax haven CFCs is that these are the major avoidance vehicles. There are, however, several problems with this approach. The first is that there are definitional problems. A country which is normally regarded as a high tax country may in practice be a tax haven for certain types of investment. An example was the United Kingdom in respect of manufacturing activity before it commenced to phase out immediate capital write-offs in 1984. The effect of the capital write-offs was generally to eliminate the tax liabilities of manufacturing businesses in the United Kingdom. If this had been achieved by abolishing income tax on manufacturing, the United Kingdom would have been regarded as a tax haven for this type of business. Thus, the existence of tax preferences removes any clear distinction between a tax haven and a non-tax haven.

2.4.6 The more general argument is that, from an anti-deferral perspective, there is no difference between these two types of jurisdiction. Offshore income derived by resident companies that is ultimately taxable in New Zealand is foreign income net of foreign taxes. (Where foreign income is earned directly by an individual, a credit is given for foreign taxes). It does not matter whether the income is sourced in a low- or high-tax jurisdiction, the deferral benefit is the same. The CD does not, however, propose the complete elimination of tax deferral by permitting companies only a deduction for foreign tax in the calculation of a their tax liability on BE regime. Instead, a credit will be given, though this is clawed back when the income is distributed. Thus, in the context of the CD proposals, New Zealand tax liabilities under the BE regime will depend on whether the foreign company is resident in a high- or low-tax jurisdiction. For this reason, the Committee advocates the adoption of a grey list as outlined in section 2.3.

2.4.7 On a practical level, there would be obvious difficulties with the alternative approach of targeting the regime on companies resident in listed tax havens. The list would never be up to date and would probably exclude apparently high tax countries which nevertheless had significant tax preferences. For this reason, no country except Japan bases its CFC regime on a formerly published tax haven list. (The Committee does propose a distinction between tax havens and other countries as part of its recommended transitional provisions but in this case, a need for exhaustive coverage and updating does not arise.)

2.5 Dividends Received by a Controlled Company, Losses and Foreign Tax Credits

2.5.1 BE income will be calculated according to New Zealand tax law. A number of special rules will, however, be required in respect of dividends received by a controlled company, BE losses and the calculation of the amount of foreign tax to be credited against the New Zealand tax liability on BE income. The Committee has had time to give only preliminary consideration to these issues but we set out below our current thinking.

2.5.2 The tax treatment of dividends received by a controlled foreign company needs to mirror their treatment in the hands of its resident shareholders. If this were not the case, it would be easy to avoid the domestic rules by trapping dividends in a non-resident vehicle. There would then be little point in changing the domestic rules. Thus, portfolio dividends received by a controlled non-resident company should be assessable to both corporate and non-corporate resident non-minor shareholders. Non-portfolio dividends received by the controlled company should also be assessable to a non-corporate non-minor shareholder but a corporate non-minor shareholder would be subject to the proposed withholding payment system if the proposed domestic tax rules applied to the calculation of the BE income. In order to avoid the multiple levying of tax on dividends, it would be necessary in the case of both corporate and non-corporate non-minor shareholders to exclude dividends received by a controlled company from another company in relation to which the taxpayer is also a non-minor shareholder.

2.5.3 This treatment would, however, be simplified if all dividends received by a controlled company, other than those received from another company in respect of which the taxpayer is a non-minor shareholder, were made assessable. It would then not be necessary for a corporate shareholder to keep separate account of portfolio and non-portfolio dividends.

2.5.4 The BE regime itself and the proposed changes to the treatment of dividends received by companies have implications for the deductibility of interest on money borrowed by a company to acquire shares in non-resident companies. The deductibility of interest expense relating to foreign investments would also be affected by interjurisdictional allocation rules. It would therefore be desirable to review the current provisions relating to interest deductibility in the context of the consideration of allocation rules.

2.5.6 The treatment of BE losses was one of the most contentious issues raised in submissions. The CD proposed that BE losses (which would be computed according to New Zealand tax rules) be "ring-fenced" to the BE regime. That is, losses would be able to be offset against any BE income of a taxpayer, but not against non-BE taxable income (i.e New Zealand- and foreign-source income taxable under current law). Any excess BE loss not able to be offset against BE income in the current year would be carried forward for offset against BE income in future income years.

2.5.7 Submissions were opposed to any ring-fencing of BE losses and generally called for unrestricted pooling of losses with a taxpayer's other taxable income. The unrestricted offset of BE losses would, however, lead to a decidedly asymmetric result as far as the New Zealand tax base was concerned. When a taxpayer derived a BE profit but the foreign tax paid by the controlled company was at least equal to the New Zealand tax liability on the BE income, no New Zealand tax would be collected. If, once the controlled company made a loss, the loss could be offset against other New Zealand taxable income, the overall result would be to diminish the New Zealand tax base. Similar problems arise now with actual branches. There is no point in implementing a regime which would further erode the present tax base.

2.5.8 Another problem would arise if taxpayers could acquire BE tax losses (by obtaining an interest in non-resident companies which were in tax loss under New Zealand rules) to shelter BE income in low tax jurisdictions. Anti-avoidance rules could cope with this to some extent but such rules have their own deficencies.

2.5.9 Considerations such as these suggest that the CD proposals will need to be tightened rather than relaxed. At one extreme, BE losses could be ring-fenced to the offshore entity for each taxpayer. This may, however, be impracticable since, where control exists, taxpayers will generally have some discretion to shift taxable income between different controlled companies, particularly where they are resident in the same country. Thus, a further possibility would be to allow the grouping of profits and losses among entities within the same tax jurisdiction. The Committee will report further on this issue.

2.5.10 The rules for crediting foreign taxes need to be integrated with those applying to losses. The CD proposed that credits be limited on an entity by entity and a source of income basis. We have yet to discuss the appropriate rules for foreign tax credits.

2.5.11 Some further discussion of various aspects of the BE regime is contained in Annex 2.